Negative interest rates, prolonged monetary accommodation and banks

Negative interest rates and prolonged monetary accommodation benefit the economy

In this paper de Groot and Haas use a canonical New-Keynesian model where the banking sector is modeled similarly to Gertler and Karadi ( “A Model of Unconventional Monetary Policy”, 2011). As such, it is the net worth of the banking sector, rather than the net interest margin per se that is key to understanding the effect of negative interest rates. They find that:

• If the Taylor rule features inertia,  negative interest rates signal a prolonged period of  monetary policy accommodation and as a result both output and inflation are boosted. 
• This is because the inter-temporal effect of signalling is larger than the intra-temporal contractionary effect on bank net worth.

Negative interest rate policies can signal a commitment to prolonged monetary accommodation
By: Oliver de Groot, Alexander Haas – University of Liverpool, University of Oxford

Persistent low interest rates may lead to a financial crisis

In this paper, Davide Porcellacchia develops a recursive model of liquidity creation based on Diamond and Dybvig (1983) to study the effect on financial stability of persistent changes in the interest rate.

The key finding of the paper is that there exists a critical interest-rate level. A cut to the interest rate below it tips the model’s economy into a financial crisis. In  principle, the economy’s tipping point can be either negative, zero or positive. Its main characteristic is that it is a function of the persistence of the change in the interest rate. Banks can withstand a deeply negative interest rate, as long as creditors expect the interest rate to increase quickly thereafter.

What is the tipping point? Low rates and financial stability
Author: Davide Porcellacchia
From: ECB